China top secrets part two: Envoy briefs His Excellency on 'two-track' economy

'Australia may lose up to 170,000 manufacturing jobs over the next 10 years.'

Satyajit Das recommends that, all things considered, China should wait and see before making a bid for the sunburnt country.

ECONO-LEAKS (a new service involved in the exclusive gathering of economic intelligence) has intercepted the following secret cable transmissions from the Chinese envoy to the leader

in Beijing on Australia's prospects. The first part (yesterday) covered Australia's vulnerability to China and the European debt crisis. Today, the final part covers the problems of a "two-track" economy and the risks of being caught in the perfect economic storm.

A fork in the economic road

The commodity boom has created a "two-track" economy as Your Excellency knows, economists prominent in the media love glib "sound bites". The mining and commodity boom benefits a small part of the economy while simultaneously creating problems for other parts.

The mining and energy sector account for less than 10 per cent of the Australian economy. This is smaller than the Australian finance sector or manufacturing industry.

Mining and mining-related sectors, such as construction, manufacturing and services industries, which benefit from mining activity, make up about 20 per cent of gross domestic product. These sectors will contribute about two-thirds of the projected 4 per cent growth in gross domestic product in 2011-12. The remaining 80 per cent of economy will contribute one-third of growth.

Mining employs 1.5 per cent of the workforce, reflecting its capital intensive nature. Unfortunately, a portion of the equipment needed is imported, adding to the current account problem. A combination of high domestic costs and the strong Australian dollar means a significant portion of project-related work is now done offshore.

The revenue earned and the overall contribution to national income does boost the economy and creates employment. But dividends and interest payments to overseas investors reduce the amount of earnings that stays in Australia.

The concentration of mining activity in Western Australia and Queensland also creates imbalances within the domestic economy. Skill shortages in mining mean rising salaries, attracting workers from other industries and placing pressure on general wage levels. It also exaggerates property price increases in some areas. This creates inflationary pressure that forces the Reserve Bank of Australia to raise interest rates.

The rising demand for Australia's mineral exports also pushed up the value of the Australian dollar. Since deregulation in 1983, one Australia dollar has purchased, on average, around US77?.

The commodity boom and Australia's high interest rates relative to the rest of the world increased the value to around US95?-100?, peaking at around US110?.

The high Australian dollar places exporters at a cost disadvantage and also makes it difficult to compete with cheaper imports. Affected sectors include key Australian export industries that are significant employers such as education services, tourism and manufacturing. Australia may lose up to 170,000 manufacturing jobs over the next 10 years, almost double its jobs lost in the past decade.

Unhappy homes

The domestic economy remains lacklustre. Consumers are affected by significant debt and weak wage growth. Public spending has fallen, reflecting pressure to return the budget to surplus. Business investment has been weak, reflecting sluggish demand.

Debt remains high. Between 1991 and 2011, household debt rose from around 49 per cent to 156 per cent of disposable income. In 1989, when mortgage rates were 17 per cent, the ratio of interest payments to disposable income was 9 per cent. Currently, even though mortgage rates are around 7.5 per cent, the ratio has increased to around 12 per cent. As households increase savings and reduce debt, consumption is lower, contributing to slower growth.

Slow credit-growth, from households reducing debt and problems in the banking sector, also constrains growth.

There are other unresolved problems. Housing prices remain high, based on traditional measures such as affordability and rental returns.

According to the latest Economist survey (published on November 26), Australian house prices were overvalued by 53 per cent, based on rents and 38 per cent measured against income relative to long-run averages.

According to The Economist, Australian home prices are overvalued by at least 25 per cent based on the average of these two measures.

The level of overvaluation is greater than in America at the peak of its housing bubble.

As Your Excellency personally experienced during his visit to Australia, no subject excites greater passion among the locals than house prices.

This is a staple of conversation. People excitedly compare the size of their mortgages and the value of their accommodation. There is heated disagreement between those who believe house prices will not fall and others who forecast substantial price falls.

The real issue is overinvestment in housing stock, which produces low or nil return. Encouraged by complex subsidies, large amounts of capital are locked up in housing, unavailable for more productive wealth-creating activities such as new industries.

In international rankings, Australia regularly performs poorly in competitiveness, productivity and innovation. This is inconsistent with the national character, which prides overachievement in competitive sports. Australia believes it can "punch above its weight".

In a recent paper entitled Productivity The Lost Decade, economist Saul Eslake found that Australia's productivity growth during the 2000s was 0.50 per cent below that of the 1990s, when it was broadly comparable with the Organisation for Economic Cooperation and Development average. Between the mid-1990s and the mid-2000s, annual labour productivity declined from 2.8 per cent to 0.9 per cent a year. Over similar periods, broader measures of productivity that incorporate capital as well as labour fell from 1.6 per cent to near zero.

The global financial crisis also significantly reduced the wealth of individuals, especially retirees. The value of their investments declined, as did income and returns from investments. The "wealth effect" limits consumption but also encourages those planning for retirement to increase their savings.

These problems mean that Australia's non-mining sector is forecast to grow at a modest 1 per cent a year, compared with the mining sector, which is forecast to grow at 5 per cent.

Where are they now?

Your Excellency, the country is a fest of complacency. Locals are convinced that there is no end in sight for the mining boom driven by China's growth.

They believe that they are protected against the problems in Europe and elsewhere. Anyone who points out the risks is dismissed as a pessimist and doomsayer.

Despite the recovery, many parts of the economy, other than the buoyant mining sector, remain subdued. The stockmarket, although not an accurate measure of economic health, remains over 30 per cent below its levels before the crisis.

Interest rates for three-year and 10-year government bonds have fallen sharply to record lows, reflecting increased pessimism among investors about economic prospects.

Australia remains vulnerable. A slowdown in Chinese growth and fall in commodity prices and volumes would affect the economy adversely.

Problems in sovereign debt and attendant pressures on the banking system may decrease available funding and increase borrowing costs for Australian banks and companies.

Overvalued house prices and high household debt increase vulnerability to an economic slowdown, with an accompanying rise in unemployment or higher mortgage rates. A credit crunch or recession could cause house prices to fall, worsening domestic conditions and affecting domestic banks.

The perfect storm for Australia would be the coincidence of those events.

Australia has some flexibility. Public debt around $A250 billion is a modest 22 per cent of GDP, providing flexibility to stimulate the economic. But this capacity can be overestimated. Before the GFC, Ireland's debt levels were modest, around 25 per cent of GDP, but the need to bail out troubled banks and the collapse of the real estate market led to debt levels increasing rapidly.

Australian interest rates are relatively high (official rates are 4.50 per cent), providing flexibility to cut borrowing costs to buffer any shock.

The currency is flexible and a fall in value of the Australian dollar would help cushion any weakness, as was the case in the 1997-98 Asian crisis and again in the GFC.

Your Excellency will also be aware that Australia's Treasurer, Wayne Swan, was recently anointed as the world's best finance minister.

His skills may assist in navigating through any crisis, should such an event occur. But it is worth noting that a previous one received similar accolades in 1984, only to subsequently preside over a deep recession, which "the country had to have".

Your Excellency has requested my recommendations for whether we should launch our bid for Australia, to be renamed the "Great Southern Province of China". I believe that we should await developments. We should be able to acquire Australia at a cheaper price in the not too distant future.

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